To the casual observer, the crude oil price has been on a slippery slope this year. Day after day it seems that the price is setting a new multi-year low, with little reprieve in sight.
As the chart below shows, that sentiment is not far from the truth, at least in recent times.
However, to the contrarian investor, the extreme pessimism about the outlook for crude has created an opportunity.
Deutsche Bank’s global strategy team, consisting of Binky Chadha, Parag Thatte and Rajat Dua, describe current market positioning in crude market as “curious”, suggesting that the price is now 8% below its present fair value.
Here’s a snippet from a research note released by the trio earlier this week explaining why.
This is unusual. As we have noted previously, a large part of the decline in oil prices since mid-2014 was a correction from grossly overvalued levels. However as the dollar kept rising, the fair value for oil kept declining and oil generally continued to trade above fair value. The most recent leg down in oil prices, even as the dollar fell after the ECB disappointed last week has left oil prices cheap to fair value.
They also note that oil shorts – traders selling crude futures in anticipation of further price declines – currently sit near record highs, another anomaly in their opinion.
Net speculative long positioning in oil hit a new low for the cycle last week. But as we have noted previously, a curious feature of oil positioning has been the stability of gross longs, with changes in net positions reflecting primarily changes in gross shorts which are now near all-time highs.
The chart below shows the relationship between gross short crude positioning and movements in the the spot price for US benchmark WTI. As it reveals, the last time gross short positioning was this high, the crude price subsequently rallied by 30%.
“Gross shorts have been rising since mid-2014 and are now near all-time highs. A short squeeze from similar levels in March saw oil prices rally over 30%”, note the trio.
A short squeeze is a scenario where traders who were previously short buy back their position, often to guard against market losses.
Chadha, Thatte and Dua believe the rise in short positioning is particularly strange given recent weakness in the US dollar.
With a rising dollar the biggest driver of lower oil prices, dollar and oil positioning have mirrored each other (inversely), especially since the big dollar up and oil down cycles began. But over the last week, oil shorts continued to rise, diverging from dollar positioning which has fallen in the wake of the ECB disappointment.
While they have stopped short of calling a rally in crude prices, suggesting that warmer weather in the US and Europe along with OPEC’s recent decision to not limit further supply may have contributed to the divergence from past relationships, the points they are making is important nonetheless.
That is, markets are already extremely pessimistic towards crude and bullish towards the US dollar. All it would take is for one, let alone both, to be proven wrong to spark a savage move higher in crude prices.
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